Embed this video

Link to this video

Individual Investors Stick With Emerging Markets

While institutional investors have been selling out of their emerging-markets ETFs amid this year's disappointing performance, it appears that mom-and-pop investors are holding on to their open-end EM mutual funds.

Jason Stipp: I'm Jason Stipp for Morningstar. We know emerging markets have had a tough time in 2013, but we also like to look at what investors are doing. Where they're putting money to work, how they're getting exposure to emerging-markets funds, and when they're taking money out of those funds.

Here to help us track that is Morningstar fund analyst Mike Rawson.

Mike, thanks for joining me.

Mike Rawson: Thanks for having me.

Stipp: You track fund flows into all different kinds of funds. We're going to talk about emerging-markets funds today. We know performance has been relatively weak compared to the developed markets, but what about the trend in fund flows--people putting money to work in emerging-markets funds or taking money out? What does that look like in 2013?

Rawson: The trend is still positive, which I think is a good thing. Maybe some people are rebalancing in and taking advantage of the sell-off in emerging markets. As you mentioned, emerging-market performance has been quite weak, but the flows are positive, but they're much weaker than what they had been historically. Historically, flows into emerging markets have been very strong, and I think that's really due to two factors.

One is the home-country bias, where people tend to be overinvested in their home country. People are starting to learn about that and kind of overcome that, and now asset allocations, investors' portfolios into emerging markets, are about caught up with where they should be on a market-value-weighted basis. That was helping boost flows.

An additional factor is performance-chasing. Emerging markets have done really well over the past 10-15 years. So, investors are probably seeing that in the rearview mirror and investing in emerging markets.

Now, this year, the story has been different. As you mentioned, emerging-market performance has been very weak. Developed-market performance is very strong. We're definitely seeing stronger flows into developed markets, and on an organic growth rate, which would be flows relative to assets, developed-market flows are actually stronger than emerging markets.

So, [emerging-markets fund flows] are still positive, but weaker than what they had been in the past.

Stipp: Do you think it's generally a good sign, though, that investors aren't leaving emerging markets en masse just because we're having a relatively disappointing year?

Rawson: Absolutely. Investors should be rebalancing, and they should stay the course. In an ideal world, as a fund flow analyst, I wouldn't really have a job. There'd be pretty consistent steady flows into each of the asset classes as they grow, and maybe some rebalancing. But in fact, what we see is a lot of performance-chasing and a lot of volatility, and that leads into the flows to ETFs.

ETF flows tend to be extremely volatile. On the ETF side as opposed to on the mutual fund side, you have a lot of institutional investors accessing the ETFs. It's very easy for institutional investors to go on the exchange and buy an ETF. They don't have to worry about loads, or they don't have to worry about gatekeepers who might limit their transaction in a mutual fund. So, institutional investors tend to use ETFs. And there we're seeing outflows. There's this divergence between mutual fund flows in emerging markets and ETF flows.

Mutual funds have positive flows, about $35 billion year-to-date. ETFs have slight outflows. And if you look at the ETFs which are experiencing the outflows, it's the big, most-liquid heavily traded ETFs such as the Vanguard FTSE, Emerging Market ETF VWO, the iShares [MSCI Emerging Markets ETF] EEM, their emerging-markets ETFs. Those ETFs are having outflows, and there I think it's the institutional investors who might be following a momentum model, in which their models will be telling them, emerging markets have had bad performance; let's sell out and maybe rotate somewhere else. Whereas the retail investor, the mom-and-pop investor potentially are still investing in their mutual funds, so on the active side we're still seeing inflows.

Stipp: ETFs are mostly passive products. Mutual funds can have active and passive products. When you look at it just on an active/passive front, is there any way that you can gauge whether investors are sticking more with active strategies, or is passive--like it is in other places of the world--starting to get a lot more investor dollars?

Rawson: That's an interesting question, because one that's on the fence is DFA, between being passive and active. They're categorized as passive, but they're not an ETF; it's in a mutual fund wrapper. DFA actually has positive inflows, pretty decent inflows, along with all the active strategies, which in general have inflows. So, I think that bolsters my theory that it's those institutions which are selling the ETFs, the most liquid ETFs.

Some of the more exotic ETFs--maybe you can think of them as semi-active or quasi-active, maybe smart beta type of strategies--those are getting inflows, but DFA is also getting inflows, and it's a passive product.

Well, DFA is very strict with who they allow to buy into their funds. They work with financial advisors to try to educate them to show them, we want to have steady inflows and we want you to be disciplined with your investment approach. We don't want you to sell every time there's a market panic. And the fact that there are inflows to DFA tells me that, DFA's funds are similar to an index fund in general--you're going to get similar returns over the long term--but they're getting inflows while the ETFs are getting outflows. That tells me that it's the momentum traders that are selling out of the ETFs.

Stipp: And what about emerging-markets bonds? This had been, in the fixed-income area, an asset class that's gotten a lot of attention as yields have been so low over the last few years. But have we seen any changes in those trends this year?

Rawson: Since the financial crisis, the flows into emerging-markets bonds have just been phenomenal. It seemed like assets in emerging-market bond funds have just doubled every year almost, and we see even core bond funds dabbling a little bit and buying some emerging-market bonds, which would be outside of the emerging-market bond fund category.

But this year, ever since the talk of the removal of Fed stimulus, the taper talk, there have been outflows from emerging-markets bond funds. The thinking there is that, well, if the Fed were to tighten, that could cause a liquidity crunch to some extent, which could impact emerging markets.

There have been outflows from emerging-market bond funds, but they haven't been as sharp as the outflows from intermediate-term U.S. bond funds. So, I think there's still some people thinking, well, I still want to have some money in emerging markets; it still may hold up if interest rates were to still rise.

Stipp: Are any specific fund firms that invest in the emerging markets doing better than other fund firms? Who is winning a lot of investor assets that are seeking emerging-markets exposure?

Rawson: One of the biggest on the active side is Oppenheimer Developing Markets. It's attracted very strong flows so far this year. A couple of the other winners include Virtus, PIMCO has a couple of emerging-markets funds which have retracting assets. On the losing side is Vanguard's emerging-markets ETF, which has had massive outflows.

Stipp: And again, as you're saying, that could be a lot of institutional money that's maybe using a shorter-term or a momentum strategy and moving that money somewhere else?

Rawson: I believe so.

Stipp: Mike, some very interesting trends in emerging markets, both on the equity side and on the fixed-income side. Thanks for joining us today.